The Profitability of Carry Trade Relative to Forecasting-Based Trading in the Foreign Exchange Market

The objective of this project is to compare the profitability of carry trade and that of forecasting-based trading in the FX market. Carry trade entails going short on a low-interest currency and long on a high-interest currency. Forecasting-based trading involves going short or long on the low-interest currency, depending on exchange rate forecasting. Comparison is based on measures of return, risk and risk-adjusted return.

The empirical work involves the following tasks:

1. Identification of Currencies and Variables

You will be provided with quarterly data covering the period 2001:1-2010:3, involving two countries on the following variables: the exchange rate between the two underlying currencies, two interest rates, two consumer price indices and two stock price indices. One of the currencies (currency x) is the funding currency (the currency denominating the short position) and the other currency (currency y) is the target currency (the currency denominating the long position).

Exchange rates are typically measured against the dollar. You must calculate the exchange rate between your assigned currencies,, such that……………………………..